Blue Chips Are Crazy Cheap

In the typical Simpsons episode, some wacky event yanks you off in one direction only to swing you in another direction entirely a few minutes later. That's exactly how I felt yesterday.

First, Fool reader truthisntstupid offered the following comment on my article, "Will This Decade Tank Your Portfolio?":

Some people are always bringing up how badly a group that included a bunch of people who were willing to buy ridiculously overvalued stocks did.

I want to know how people that demanded a dividend of >3% and a P/E more in line with (or less than) the S&P did as a group.

I couldn't agree more, so I decided to dig up those numbers.           

Survey says ...
Since investors were oh-so-willing to pay up for even unprofitable companies a decade ago, I used a revenue multiple instead of the price-to-earnings ratio and, sure enough, the numbers played out just as I (and truthisntstupid) might have imagined.

Looking at all stocks with a market cap of $100 million or more, the median return between the beginning of 2000 and today was 19.3%. The median price-to-revenue multiple for that same group was 2.42.

Now if we strip that group down to only stocks with a price-to-revenue multiple below the median and a dividend above 3%, the median return jumps to 88.5%. And if we go the other way? If we look only at stocks with multiples above the median and no dividend at all, the median return drops to a 50.2% loss.

That doesn't mean that there weren't losers in the former group and winners in the latter. Though Ford (NYSE: F  ) is regaining darling status today, it's had a pretty ugly decade. It had a below-median revenue multiple and a 3.5% dividend back in 2000, but its stock has still lost 53% of its value. On the flip side, Apple (Nasdaq: AAPL  ) didn't (and still doesn't) pay a dividend and had an above-median multiple, but its turnaround that did (and continues to) wow investors helped the stock deliver impressive returns.

But the message is clear and really nothing all that new: Look for stocks with low valuations and solid dividends, and you'll up your chances of success.

But now the story changes
When I stepped back and looked at those numbers, though, I found myself a little surprised by one number in particular. Above, I noted that the median return for all stocks with a market cap of $100 million or greater between 2000 and today was 19.3%.

But how can that be? Wasn't the past decade a lost decade for investors?

Sure, 19.3% over a decade is hardly worth crowing about -- it's less than 2% per year. But it's not the nasty loss that's so often cited for the past 10 years. So what gives?

It all depends on where you're looking. What we generally spend our time focusing on either the Dow Industrials or the S&P 500, both of which are large cap indexes. Over the past 10 years, the Dow lost 3.2%, and the S&P 500 dropped 20%. But the small-cap-focused Russell 2000? That's up 40%!

For an entire decade now, small caps have been kicking large-cap butt all over the market.

Source: Yahoo! Finance.


Source: Yahoo! Finance.

Are small caps simply better investments than large caps? Well, they can be. Because of their size, small caps typically have a lot more room to grow, and they're often ignored by Wall Street, giving you the opportunity to jump on them before everyone else comes running.

But the outperformance of small caps over the past decade has a much simpler explanation. Back in 2000, the median price-to-earnings ratio on stocks with a market cap of $10 billion or more was a whopping 32. For stocks below the $10 billion threshold, the median P/E was less than 16. That's right, by and large, large caps had valuations that were more than twice that of their smaller brethren. So it's no wonder small caps have outperformed ever since.

But that's not the case today. In fact, the two groups have changed places over the past 10 years. Currently, stocks with a market cap of more than $10 billion are the cheaper group, with a median P/E of 16.7 versus 17.1 for the small fries.

What does this mean?
It means that right now we can buy shares of many of the best and most admired companies in the world at prices we haven't seen in a long, long time. Even at the depths of the Internet bust in October of 2002, the big-cap club fetched a median P/E of more than 21.

But, you may wonder, if the group has fallen this far, couldn't it fall further? Sure it can. The market isn't always long rationality. That said, I think today's prices look pretty attractive, so I'm comfortable buying today and then adding to those positions if prices get even cheaper.

As far as I'm concerned, keeping it nice and simple is a winning strategy right now. Specifically, that means focusing on quality, sticking to the stocks that still have low valuations, and demanding a decent dividend. Here are a few stocks that fit those criteria.

Company

Return on Capital

Forward Price-to-Earnings Ratio

Dividend Yield

ExxonMobil (NYSE: XOM  ) 15.3% 10.9 2.7%
Intel (Nasdaq: INTC  ) 22.9% 10.8 3.2%
Abbott Labs (NYSE: ABT  ) 10.9% 11.3 3.4%
Lockheed Martin (NYSE: LMT  ) 32.9% 10.4 4.2%
Johnson & Johnson (NYSE: JNJ  ) 16.4% 13 3.4%

Source: Capital IQ, a Standard & Poor's company.

I personally own shares of Intel, Abbott, and J&J, and both Exxon and Lockheed are high on my watch list -- though writing about them here now restricts me from buying shares for a while.

Have some top large-cap picks of your own? Or do you think my faith in blue chips is batty? Head down to the comments section and sound off.

Looking for yield in this world of painfully low-yield bonds? My fellow Fools have uncovered their favorite 13 high-yielding stocks. To get this free report simply click here and enter your email address.

Intel is a Motley Fool Inside Value pick. Apple and Ford Motor are Motley Fool Stock Advisor recommendations. Johnson & Johnson is a Motley Fool Income Investor pick. Motley Fool Options has recommended buying calls on Intel. Motley Fool Options has recommended a diagonal call position on Johnson & Johnson. The Fool owns shares of Apple, ExxonMobil, Intel, and Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Fool contributor Matt Koppenheffer owns shares of Abbott Labs, Intel, and Johnson & Johnson, but does not own shares of any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his Motley Fool CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or on his RSS feed. The Fool's disclosure policy assures you no Wookiees were harmed in the making of this article.


Read/Post Comments (23) | Recommend This Article (102)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 28, 2010, at 4:52 PM, PeyDaFool wrote:

    Congrats, Matt! Awesome and enjoyable article.

  • Report this Comment On October 28, 2010, at 5:54 PM, 102971 wrote:

    Very timely article, Where do IBM and Microsoft fall in this category.? I was suprised to see neither mentioned.

  • Report this Comment On October 28, 2010, at 6:31 PM, mtracy9 wrote:

    Blue Chips are still cheap, but they were "crazy cheap" a couple of years ago when we were the middle of a recession.

  • Report this Comment On October 28, 2010, at 7:12 PM, richbatty wrote:

    Not explicitly mentioned is that the indexes and hence the results are capitalization weighted while the figures that you calculated are equal weighted. Any problems like we experienced in the last decade among the super-caps that dominate the S&P500 cannot be rescued by the smaller caps in the index while equal weighted is capitalization agnostic.

  • Report this Comment On October 28, 2010, at 7:41 PM, timeinthewind wrote:

    While this line of thinking does lead to good companies and dividends, there is no mention of the relationship between potential growth and P/E. Large caps generally should have lower P/Es than small caps because it is a lot harder to grow $1B by 10% than it is to grow $10M by 10% so you don't see as much potential growth priced in. Don't get me wrong I like many blue chip prices right now and own some of the companies the article identifies but I'm not expecting them to rocket up like I might if I was buying a fast growing, young small cap.

  • Report this Comment On October 28, 2010, at 8:15 PM, scanlin wrote:

    These are good candidates for covered calls, too. For example:

    INTC at 20.50, buy-write the Nov 21 for 20.33, plus get the 16 cent div that goes ex-div on Nov 3. Make 25% annualized if stock is flat. More if it rises and is called away.

    XOM at 66.22, buy-write the ITM Nov 65 for 64.55, plus get the 44 cent div that goes ex on Nov 9. Annualized return if flat > 22%.

    MikeS

    http://www.borntosell.com

  • Report this Comment On October 28, 2010, at 8:40 PM, TheDumbMoney wrote:

    Well, I certainly agree with ya, and own four of the five of these, though it has earned me a 30ish CAPS rating so far!

  • Report this Comment On October 28, 2010, at 8:55 PM, Notfooled1 wrote:

    The preceding post is SPAM.

  • Report this Comment On October 28, 2010, at 9:49 PM, lctycoon wrote:

    I can think of quite a few stocks that look pretty good that this article doesn't mention (but kudos, Matt - I always like your articles).

    MO, MSFT, IBM would all probably fit pretty well into this same theme. There are some large caps with similar numbers and even lower P/Es that are still having incredible numbers - some of which weren't even hurt by the recession. (TRV comes to mind here, but its dividend is only 2.4%).

  • Report this Comment On October 28, 2010, at 9:53 PM, rd80 wrote:

    Good piece Matt,

    From your list, I own JNJ. XOM does look attractive, but I like CVX a little better and added to my position recently.

    The PE isn't much below average, but I think MCD could fit your template - and I own some of that too.

    Fool on!

    Russ

  • Report this Comment On October 28, 2010, at 10:08 PM, topsecret10 wrote:

    I'll keep searching for the "next bluechips",you can have the old ones..... The only one that I would buy of these Is Intel.... TS

  • Report this Comment On October 28, 2010, at 10:14 PM, breaktrack wrote:

    You simply can't go wrong with good stocks like P and G , Duke, Home Depot etc. These companies one would hope that they be around for awhile through thick and thin. These days....who knows!

  • Report this Comment On October 28, 2010, at 11:54 PM, Rockfish88 wrote:

    So if you had a bunch of money in a stock that was going nowhere fast, say ATVI, would you dump it for a basketful of these? Just curious....

  • Report this Comment On October 29, 2010, at 12:29 AM, topsecret10 wrote:

    Rockfish88 wrote:

    So if you had a bunch of money in a stock that was going nowhere fast, say ATVI.... Do you have a profit or a loss In the company ? I bought some calls that expire In Jan,doesn't look like I will be exercising @ $12.50. Been dead money for a long time. I like the company,but there are better places to put your cash. The sector Is cold,but that does not mean that It cannot heat up. The entire market Is overpriced In my opinion. I am raising cash for a possible dip In November... TS

  • Report this Comment On October 29, 2010, at 12:36 AM, topsecret10 wrote:

    Nice links truthisntstupid .... I like (PNNT) quite a bit for a dividend play. And, no I sold (EK) for a triple,and was considering buying It back under $3.75 then It popped a little. May still buy some back... I want to go back and look at my charts again.... I'll keep you posted.... TS

  • Report this Comment On October 29, 2010, at 1:41 AM, realsplita wrote:

    Just bought xom, just a soild company all around

  • Report this Comment On October 29, 2010, at 10:22 AM, mikecart1 wrote:

    I don't admire any of those companies and therefore won't be buying any of them. Their yields only look good because current CD rates are at like 1.25% annual for 5 year CD's. So obviously a 4% dividend will be seen as awesome but people don't account for inflation and that 4% quickly becomes unimpressive. I stick with the 10%+ yields with stock appreciation. That's how I roll!

  • Report this Comment On October 29, 2010, at 11:03 AM, hellomojo wrote:

    recently added Monsanto, McDonald's, and Exceleron to my portfolio..all of which seem to fit the above model.

  • Report this Comment On October 29, 2010, at 1:25 PM, PDQCarrera wrote:

    Seems to me there's still lots of bandwagon activity on XOM whilst I continue to prefer CVX.

    JNJ was a great value in July-Aug but IMHO not now. I'll wait til the next <60 dip before increasing my position.

  • Report this Comment On October 29, 2010, at 3:28 PM, TMFKopp wrote:

    @truthisntstupid

    "We both knew how that would turn out - didn't we?"

    Yup, but isn't it still fun to see the numbers? :)

    @rd80

    "From your list, I own JNJ. XOM does look attractive, but I like CVX a little better and added to my position recently.

    The PE isn't much below average, but I think MCD could fit your template - and I own some of that too."

    Yeah, CVX easily could have made the list, but when I put together a list like this I typically like to try and get some industry diversity in there. But that's certainly another one high on my list.

    As for MCD, I own it and I'm not a seller, but I'm not crazy about the price right now.

    Matt

  • Report this Comment On October 29, 2010, at 3:37 PM, TMFKopp wrote:

    @timeinthewind

    "While this line of thinking does lead to good companies and dividends, there is no mention of the relationship between potential growth and P/E. Large caps generally should have lower P/Es than small caps because it is a lot harder to grow $1B by 10% than it is to grow $10M by 10% so you don't see as much potential growth priced in."

    So here's the thing... that's a definite gray area.

    You're absolutely right that smaller companies have more room to grow earnings. However, larger companies are generally more stable and predictable. So when going through the valuation math, a small cap is going to get a boost from added growth potential but it'll get dinged for risk. Larger companies, on the flip side, will typically get less of a growth boost, but will get a lift due to the relative safety of their earnings.

    As an example, let's just say that analysts thought that both P&G and First Solar were going to grow 15% per year. Are you going to value both the same? Heck no! P&G should get a richer valuation because it's a larger, better, more stable company while First Solar is still in an emerging area.

    Of course the growth projections of P&G and First Solar are not the same, but the by the same logic the valuations won't have the kind of gulf that the relative growth differences would imply.

    Matt

  • Report this Comment On October 29, 2010, at 3:45 PM, TMFKopp wrote:

    @102971

    "Very timely article, Where do IBM and Microsoft fall in this category.? I was suprised to see neither mentioned."

    By the numbers IBM is a definite fit on ROIC and P/E-based valuation. Its dividend isn't all that eye-catching at 1.8%, but it has a really low payout ratio which gives it significant room to raise the payout. Bill Miller certainly seems to think IBM is attractive: http://www.fool.com/investing/general/2010/10/22/bill-miller...

    As to other stocks not mentioned, there were some I couldn't include because the Fool's trading restrictions (http://www.fool.com/help/index.htm?display=about02) prevent me from writing about any stock I've purchased within 10 days of the article's publish date.

    Matt

  • Report this Comment On October 30, 2010, at 2:30 PM, TheDecider wrote:

    In other words, Matt has been snapping up shares of MSFT.

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